The Death of the Federal Funds Rate?

I referenced a paper nearly a month ago by Michael Woodford and Vasco Curdía that examined the Federal Reserve balance sheet as an instrument of monetary policy. Hopefully, I will have some time soon to briefly discuss the dynamics of their model. Nonetheless, the recent behavior of the Federal Reserve has been considerably different than in the past. Since the federal funds rate reached (or nearly reached) its zero lower bound, the Federal Reserve enacted a number of measures through the expansion of its balance sheet. As Benn Steil and Paul Swartz note in a recent op-ed in WSJ Europe, this poses interesting questions about the exit strategy of the Federal Reserve, in particular, the role of the federal funds rate:

Between August and November 2008, the Federal Reserve swelled its balance sheet to $2.2 trillion from $940 billion to ease a potentially catastrophic credit crunch brought on by fears of cascading defaults. The assets added to the balance sheet are today comprised overwhelmingly of mortgage securities. The purchase of these securities had the parallel purpose of shoring up a collapsing housing market.

Much of the money the Fed conjured to buy these assets made its way into reserves, which the banks chose to hold at the Fed. Excess reserves—reserves held above and beyond what the Fed requires of the banks as a minimum—soared to more than $1 trillion from $2 billion.

As long as this money remains parked at the Fed, it poses no risk of fuelling inflation—just like cars parked in garages can’t tie up traffic. But at some point the banks will muster the courage to begin transforming these near zero-yielding reserves into credit, and the Fed knows it then will have to act to prevent exuberance from pushing up prices too far and too fast—in traffic terms, to stop the cars from streaming onto the roads all at once.

In normal times, the Fed would do this by selling Treasury securities from its balance sheet, which the banks pay for using the excess dollars they’ve parked in reserves. Those dollars are then no longer available to the banks to create credit.

But these are not normal times. The Fed doesn’t have an excess stock of Treasurys to sell—its holdings are at roughly what they were before the crisis. It has only a vast excess pile of politically toxic assets—the mortgage securities it has amassed since 2008. Dumping them would depress the housing market further by pushing up mortgage rates and enrage an already Fed-wary Congress.

So what will the Fed do? Chairman Bernanke has been anxious to assure the markets that he has other tools in his chest, two in particular. The first is to entice the banks to move a portion of their reserves to term deposits, which would lock up that money for a fixed period. The second is to use “reverse repos,” in which the Fed continuously borrows money from the banks, using its Treasury securities as collateral. Both strategies soak up reserves.

But both strategies have a hidden “catch”—the Fed will lose control over interest rates. Since 1994, the Fed has announced its so-called fed-funds target rate, or the rate at which it intends to see banks lend reserves to each other overnight. By buying or selling securities, the Fed jiggers interest rates to keep them at the target. But if the Fed is no longer willing to sell securities to tighten policy, and if it is instead determined to drain a specific quantity of reserves through term deposits, it will have to pay whatever rate the market demands. Logically, then, the fed-funds rate will mechanically shadow the term deposit auction rate.

Reserves have always been the tool of the Federal Reserve through open market operations. The Fed has, for some time now, targeted the federal funds. What this means is that the Fed accommodates fluctuations in the demand for reserves with corresponding changes in supply in order to keep the federal funds rate at its target.

With the federal funds rate at the zero lower bound, the Fed has used a number of other means to conduct monetary policy as Steil and Swartz detail above. A number of people have pointed out that, with the federal funds rate effectively at zero, the Fed can use the interest paid on excess reserves as a policy tool. However, I believe that a number of these individuals have missed the fact that this change in policy tools involves a significant change in operating procedures.

The Fed does not directly control the federal funds rate. As a result, the Fed adjusts the level of reserves to maintain its target. The Fed does, however, control the interest rate on excess reserves. As a result, they can change the interest rate to adjust the level of bank reserves. There is a significant difference in policy. In the first scenario, the Fed is adjusting bank reserves to change the path of the federal funds rate. In the second scenario, the Fed is adjusting the interest paid on excess reserves to change the path of bank reserves. As a result, the size and composition of the Federal Reserve’s balance sheet is increasingly more important. In fact, one could argue that the Fed’s balance sheet will be a better indicator about the path of monetary policy than the federal funds rate — even after the funds rate rises above the zero lower bound.